Have you experienced making loans from your friends and relatives for your startup business? Startup business financing from friends and family is one of the most common ways small businesses begin, according to the Small Business Administration. And while there are some road bumps that can come when money and loved ones mingle, there are also some tremendous benefits.
In this guide, we cover the most common variations on friend and family loans for business startups and what benefits and disadvantages you might experience along the way.
Friends and Family Startup Loans
Friend and family startup loans occur when people you know fund your business in either an official or unofficial capacity. These types of loans tend to take on one of several formats, which we’ve summarized below.
- Cash Gifts. In some cases, a friend or relative simply wants to become your patron — a fancy word that means they want to fund your endeavor out of sheer support for you or because they believe in your cause or idea. They don’t want a return on that investment, other than the pleasure of seeing you succeed. These situations might lead to a cash gift that you can use to start your business. You and your patron must be careful, though, because gifts can get expensive if they exceed IRS gift tax thresholds. As of 2018, a person can gift another person $15,000 per calendar year without paying a gift tax. If you’re calling the funding a gift, your patron may want to keep it under that amount.
- Traditional Loans. Friends and family may wish to loan you the funds and expect you to pay it back. While these loans might not come with a credit check — and individuals can often be more flexible with their terms — you may end up owing a monthly payment with interest or be required to pay back the lump sum at an agreed upon future date with interest.
- Investment. If your new business idea resonates enough with friends and family, they may want to become part of the process, which could result in them investing in your business as a partner of some kind. This means the investors become part owners or have some continuing interest in the company. They may not require the funds be paid back with interest but might accept a share of profits in the future. Depending on how well your business does, this type of funding can work in the investor’s favor.
The benefits of going to friends and family for startup financing include speed, flexibility, and support.
Your friends and family know and believe in you, so they’re not going to require some of the hoop jumping a bank might. That makes it easier to get money for your business idea — even if that idea doesn’t check all the traditional marketable boxes.
Since individuals have a lot more flexibility in how they handle investments and loans than other lenders, you may also be able to work out more favorable terms with a friend or family member. Perhaps you receive money you don’t have to pay back for five years. You might be given a loan with the understanding that you’ll both sit down to talk about payments in a year and terms will depend on how the business is doing at that time. A friend might help fund your business in exchange for free services once you get started. These are all options you don’t have with banks.
A third big advantage is that when family or friends invest in your business — even if they don’t become a partner — they tend to remain attached to your success. That translates to free word-of-mouth marketing, online sharing and other support, which you certainly don’t get from many traditional lending sources.
The biggest disadvantage is that you’re dealing with friends and family. That can put some weird pressure on your social dynamic, and it could mean that the person thinks they have a right to interfere in or advise you on your business. That’s not always welcome, which means you need to establish some written ground rules about the financial relationship if you allow friends or family to fund your business idea.
Another potential downside to this type of loan is that it doesn’t do anything for your personal or business credit, which means you can’t leverage it in the future when seeking other types of business capital or investment options.
Don’t treat the transaction as casual. Be professional and official, even if your loved one is willing to be flexible about the finances. Draw up an agreement in writing, develop a plan for how the money will be handled and paid back and sign it in the presence of a witness or notary to make it even more official.
Then treat your obligation exactly how you would if you were dealing with a bank. Make payments as agreed or rework the terms in a professional way.
The Bottom Line
Anyone can qualify for a friends and family loan, which makes this one of the easiest first steps for starting a business — plus, you’re only limited by what your loved ones are able and willing to do for you. We recommend being specific about your financial needs and business plan, though, to put your investors more at ease. Some steps you might want to take when borrowing from friends and family include:
- providing a business plan that shows how the money will be used
- being specific about how much money you need
- detailing payment plans and terms, so everyone knows exactly how the money will be paid back, and
- working only with trusted friends and family you know can keep business and personal lives as separate as possible.
This article originally appeared on seekcapital.com by Jon Zacharias